A synthetic position in forex trading is a position constructed from two or more forex positions with two or more common currencies. For example, if I have a position in the GBPJPY and another in the NZDJPY, you may have a synthetic position in GBPNZD depending on the direction and lot size of the JPY currency for each position.

If you trade a portfolio of currencies you will want to make sure you are performing analysis on any synthetic positions you have as all your positions when accumulated may show you positioned heavily in a particular direction according to the synthetic position you have on.

Why synthetic positions?

Reasons for why you should understand and know about synthetic positions are as follows:

  • Instead of opening or having multiple currency positions open at once, you might be able to compress your positions into one upon your analysis of the overall synthetic position of your portfolio.
  • You may be able to analyse what your synthetic position from all open trades in your portfolio and thereby mitigate the risk by opening positions in the synthetic pair.
  • You may be able to create a synthetic position if your forex broker doesn’t offer the currency pair you are hoping to trade.
  • You may be able to achieve a tighter spread with a synthetic position than you otherwise would trading the physical currency pair.

In this article we will emphasise the second point raised above by exploring the opportunity missed if our forex broker doesn’t offer a currency pair that pays interest on currency positions.

What is a synthetic position?

The best way to explain a synthetic position is by way of demonstration.

Currently, Oanda does not offer the ability for forex traders to trade on the NZDJPY currency pair directly. One advantage of trading this currency pair is that at this present moment being long NZD has an interest payout of 7% per year, whereas being short JPY is a charge of 0.32% per year.

Therefore, if you can achieve going long NZD and short JPY and can hold this position you’d be pocketing the difference every day.

So what do we do?

(All interest rate charges and payments have been taken from Oanda’s Interest Rate section .)

How can you construct a synthetic position of NZDJPY in Oanda?

We could do it any manner of ways:

  • Long USDJPY & long NZDUSD.
  • Long GBPJPY & long NZDGBP.
  • Long EURJPY & short EURNZD.

Can you see the pattern?

If we’re trying to achieve a synthetic position of NZDJPY we have to find a way to neutralise the common currency in both positions.

Calculate Interest

Before we look at a synthetic position, let’s first understand how interest has been calculated on any currency position.

We’ll look at the volatile GBPJPY pair, currently Oanda pays the following:

  • Long GBP positions pay at 4.35% per annum
  • Short JPY positions charged at 0.32% per annum

If we were to go long GBPJPY (which in effect is buying/investing Pounds and selling/borrowing Yen) then we’d receive interest on a daily basis, as the interest received is greater than the interest paid.

CurrencyTrade DirectionCurrent PriceLong PositionShort Position
GBPJPYLONG215.08Long 100,000 GBPShort 21,508,000 JPY $$100,000 \times 215.08$$

If we held this position for a year then our interest would be calculated as follows:

$$GBP = 100,000 \times 4.35\% = GBP 4,350$$

$$JPY = 21,508,000 \times -0.32\% = JPY -68,825.60$$

If we convert the JPY charges to GBP, and we’ll further assume the GBPJPY has appreciated up to 220.10 then our charges would be calculated:

$$JPY -68,825.60 / 220.10 = GBP -312.70$$

Therefore, our total interest received throughout the year would be the total of these two amounts:

$$GBP 4,350 - 312.70 = GBP 4,037.30$$

It’s quite a simple process calculating interest rates, but as it is with riding a bicycle it takes going over a few times.

Synthetic Position Interest

Extending this example let’s see if we can find a way whereby we can take advantage of the interest rate differential by being long the highest paying currency and being short the lowest charging currency.

Such a position is the NZDJPY, which Oanda does not currently offer to trade.

Therefore, we will need to construct a synthetic position to take advantage, here’s how we would contrauct this:

CurrencyTrade DirectionCurrent PriceLong PositionShort Position
NZDUSDLONG0.6175Long 100,000 NZDUSD 61,750 = 100,000 \times 215.08
USDJPYLONG115.88Long 61,750 USDJPY 7,155,590 = 61,750 \times 115.88
Net NZDJPYLONG71.5559LONG 100,000 NZDShort 7,155,590 JPY

Notice again the purpose of the synthetic position is to neutralise the common currency, in our case above the USD. If your broker only allows you to trade standard or mini lots, then you would need to calculate the nearest number of lots, which means you may have a slight position in the common currency pair.

For example, in the above positions, if only mini and standard lots have been offered, you’d likely trade 60 mini lots in the second position, equating to a long position in the USD of 60,000 netting a slight short position of 1,750 USD.

Let’s assume again for the sake of this example the interest rates for the NZD stay at 7% and the JPY at 0.32%.

Here’s our process for calculating the interest collected:

  1. Multiply the number of long units by the interest rate.

$$NZD = 100,000 \times 7\% = NZD 7,000$$

  1. Multiply the number of short units by the currency’s interest rate.

$$JPY = 7,155,590 \times 0.32\% = JPY -22,897$$

  1. Convert the currency back to your base currency. We’ll assume for this example that the NZDUSD pair is at 0.6375, and the USDJPY pair is at 114.76:

$$USD = NZD 7,000 \times 0.6375 = USD 4,462.50$$

$$USD = \frac{JPY -22,897}{114.76} = USD -199.52$$

$$USD = 4,462.50 - 199.52 = 4,262.98$$

What are the disadvantages of synthetic positions?

Probably the most prominent is the fact that you don’t have a direct chart to look at and see where support, resistance, or whatever indicators you enjoy plotting are. If you have a charting package with forex data you could probably work around this restriction by creating code and plotting such a chart.

Or, if you don’t have WLD, you could use a free charting service such as Trading Charts and simply enter the synthetic currency into the box underneath the table - i.e. NZDJPY. You can then play with the resulting bar chart according to Trading Charts’ selections.

By looking at a chart you are able to gauge how much you’ll need in reserve to hold the positions for margin requirements.

Calculating Synthetic Portfolio Position

By seeing the math on how to calculate a synthetic position we may at times inadvertently have a big synthetic position from the result of all of our forex positions.

Let’s assume each of the following trades have been opened with one standard lot:

  • Long GBPJPY at 215.21
  • Short USDJPY at 116.32
  • Long NZDUSD at 0.6201
  • Long AUDUSD at 0.7032

To find out if we have any strong synthetic position on we need to calculate each currency position:

CurrencyTrade DirectionCurrent PriceLong PositionShort Position
GBPJPYLONG215.21Long GBP 100,000Short JPY 21,521,000
USDJPYSHORT116.32Short USD 100,000Long JPY 11,632,000
NZDUSDSHORT0.6201Short NZD 100,000Long USD 62,010
AUDJPYSHORT84.95Short AUD 100,000Long JPY 8,495,000
Net GBPLONG-GBP 100,000-
Net JPYSHORT---21,521,000 + 11,632,000 + 8,495,000 = JPY -1,394,000
Net USDSHORT---100,000 + 62,010 = USD -37,990
Net NZDSHORT--NZD 100,000
Net AUDSHORT--AUD 100,000

As you can see from this table our JPY position is actually quite small, and our USD exposure is also relatively small. In essence the collection of all our positions rolls up to represent more of a long GBPAUD, and long GBPNZD trade than it does with all those four positions on.

By being aware of the synthetic nature of your positions it can help you to understand what your system has been positioned towards. If upon looking at the forex charts for these positions you find you would not be long the GBPAUD or GBPNZD then you should seek to reduce your exposure.

You could perhaps take some small positions in the opposite direction of your synthetic long GBPAUD and synthetic long GBPNZD to help minimise risk too.

Conclusion

In this post we explored more about synthetic positions. One of the popular approaches to having synthetic positions on is that it can help create currency pairs that may not be offered by your forex broker.

However, another approach is to analyse your portfolio exposure to determine if collectively from all your open positions you have too much exposure in a synthetic currency pair. We explored how you could mitigate this risk by opening up additional positions to mitigate the risk.

So, hopefully with this short article on synthetic positions it has helped widen your scope on what is tradable in the forex market, and opened up new opportunities for you. With interest rates on the rise in certain countries carry trading like this should further your interest over the coming months and years.